As European leaders struggle to get their sovereign debt crisis under control, banks and other financial institutions around the world suddenly are preparing for the once unthinkable prospect of a partial or even full breakup of the single currency zone.
Optimism over plans to turn the euro zone into a “fiscal stability” union, announced at a summit last week, was fading earlier this week, when Italian bond yields rose back above the 6.5 percent level. On Monday, Moody’s warned that it may downgrade European sovereign debt because the summit didn’t address the problem in a credible way. The euro fell on Monday to $1.3267, down 0.89 percent.
“I believe there is around a 30 percent chance of something going quite badly wrong in Europe,” says Eric Lascelles, chief economist at RBC Global Asset Management. He said the risks included some sort of euro zone breakup, the failure of a big European bank or a default by Italy or Spain.
Investors are now sorting out two questions—what exactly are the risks, and how can they be mitigated?
“Developments over the past few weeks have highlighted that some form of euro zone breakup is a very real risk,” Nomura currency strategist Jens Nordvig warned last month in a report that explicity urged investors to review the redenomination risks of contracts that they own. In the event of a euro breakup or default, they could suddenly find that a euro-denominated contract is now payable in a new national currency that is worth less than the euro.
The €38 trillion in global outstanding euro-denominated equities, credit and bonds would be affected in different ways. The main question for investors to consider is whether the instruments are governed by local or international law, with redenomination risk rising for locally governed instruments. Few contracts have language specifically addressing such issues. But in general, a country that exits the euro zone is likely to redenominate its local law debt. However, it lacks the legal power to change a contract subject to the laws of another country, according to Nordvig.
The greatest amount of redenomination risk is concentrated in sovereign debt, which also happens to have the highest levels of financial risk. Most sovereign debt is subject to local law—€5.6 trillion in local debt vs. €1.2 trillion in foreign law debt. In the case of Greece, for example, 94 percent of its sovereign debt is subject to local law, and therefore, to redenomination. The other great concentration of redenomination risk is in the loan market, where €11.3 trillion was issued under local law and €4.2 trillion under foreign law.
The risks of redenomination are lower in the European corporate bond market, where €3.6 trillion of financial company debt is subject to local law and €7.3 trillion is subject to foreign law. In the market for non-financial company debt, €992 billion is subject to local law, and €709 billion to foreign law.
Nordvig says foreign law debt should trade at a premium to riskier local law debt, barring a disorderly sovereign default or a total breakup of the euro zone. In the event of a total breakup—still viewed as remote—the euro would cease to exist and most likely be replaced by a new European Currency Unit, reverting to the system that was used before the introduction of the euro in 1999.
The nature of a euro exit could take one of several forms, according to Peter Green, a London-based partner with law firm Morrison Foerster. “If one or two countries leave the euro in a disorderly fashion, with no real international accord, we get into more dangerous territory,” he said. “In hindsight, much of the systemic damage created by Lehman’s demise reflected the disorderly nature of its collapse.”
In the event of a euro exit, total breakdown, or default, the fate of many contracts will be resolved in court. But that is bound to be a lengthy and expensive process. So in many cases, the market may resolve differences by creating new financial instruments, according to James Wood-Collins, CEO of Record Currency Management in London.
What might those contractual differences be? Wood-Collins offers the hypothetical case of a German pension fund settling contracts in the event that Germany leaves the euro. Even if those contracts were governed by local law, the pension fund might want to settle them in euros, which presumably would be cheaper than a new deutschmark.
What could investors do to protect themselves from being paid off in deflated euros? Wood-Collins says the best strategy would be to hedge those euro contracts into “legal tender of country” contracts, that specify the investor will be paid off in whatever the currency of the country happens to be. Such contracts don’t yet exist in the mainstream. They would be expensive to produce. But once written, they would provide pension funds and other institutions “absolute certainty” of protection, he said.
Another option is the use of CDS-like instruments that would insure against currency related losses, according to Wood-Collins. Investors also can take care to make sure their contracts are written in jurisdictions that would have the most favorable terms, from their perspective.
On December 5, European nations, minus Britain, agreed to binding intergovernmental treaties to limit sovereign debt in more enforceable ways. The agreement limits structural debt to 0.5 percent of GDP, and imposes fines on countries in which deficits exceed more than 3 percent of GDP. They agreed to accelerate the deployment of the 440 billion euro European Financial Stability Fund and its successor bailout fund, the European Stability Mechanism. The states also will lend an additional 200 million euros of bailout money available to the IMF.
It is far from clear that this set of measures—the fifth in 19 months—will be sufficient to resolve the crisis. It isn’t clear where the bailout funds will get all of their promised money, which is supposed to come from investors. And member states have the power to waive fines on governments that breach the deficit limits, which reduces the credibility of enforcement measures.
“There can’t be a single currency without economies heading toward more convergence,” French President Nicolas Sarkozy warned earlier this month. “If living standards, productivity, and competitiveness gaps widen among euro zone countries, the euro will sooner rather than later be too strong for some and too weak for others, and the euro zone will explode,” he said.
